The author is a Forbes contributor. The opinions expressed are those of the writer.

Loading ...

Loading ...

This story appears in the {{article.article.magazine.pretty_date}} issue of {{article.article.magazine.pubName}}. Subscribe

Given today’s ultra-low interest rates, more and more retirees are looking for safe ways to generate income. In the past, you could just walk down to your local bank and nab 3%-4% or more on a one-year CD. But those days are gone for now and, every so often, I get asked about the pros and cons of using Options (primarily covered calls) to boost retirement income.

Long story short, writing or selling covered calls can be an effective strategy; but it’s not for everyone. Mostly because it can be time consuming and not as lucrative as many people hope.

As a quick primer, a covered call is one of the most popular and basic strategies for Options Trading. It’s a process whereby you earn money (a premium) by selling someone the “option” to buy stock you already own at a future date and price.

Spoiler alert! As a general rule, investors with less than $500,000 along with those who are more conservative (like retirees) may want to shy away from options like these. I emphasize these two investor types because of the way in which Options trade, average account size, and typical holdings in a retirees portfolio.

To start, Options trade in contracts. Basically, 100 shares equal 1 contract. That may sound simple enough but, to truly generate solid income from the Option itself, investors may want to be in a position to trade at least 5 contracts (500 shares). Simple math illustrates that 500 shares of a $50 stock equates to a $25,000 holding in one company. For the average retiree with $100,000, or even $250,000, that’s a large position for one holding... and can create single-stock risk where a negative move in that one stock can impact an entire portfolio.

It’s not that you can’t make money by trading a smaller number of contracts (fewer shares), or that people with only $100,000 can’t trade options. However, the trading costs and potential tax bite can dramatically lessen the income you earn. Furthermore, conservative investors generally own large, well-known companies that don’t fluctuate much in price. Because higher premiums tend to go to riskier or more volatile stocks, there’s usually less money on the table for risk-adverse retirees.

When covered calls are discussed in other forums you’ll often find examples that point to, say, a $35 stock offering a $3 premium per share. With 300 shares, an investor would net $900 of extra retirement income. It sounds great and worthwhile but, again, it assumes a lot, including: 1) you have over $10,000 invested in that one company, 2) you can wait four, five, or even six months to see if the stock gets sold, and 3) that the stocks you own are paying premiums at those levels.

As a more realistic example, take a widely-held and popular dividend paying stock such as Southern Company (SO). It’s currently trading at $44.20 and offers a premium of $0.47 per share, with a strike price of $47, and the contract expires in November. Therefore, if you owned 100 shares (or $4,420 worth of SO) you would collect less than $50 on this options trade. Throw in a couple transaction costs to get in and out of the trade and it’s more like $30, not including tax consequences. This is only a general example, and $30 can buy some retirees an early bird lunch and a matinee movie, but is it worth all the time, energy and effort?

There is, of course, another potential benefit: if you sold the stock for a profit of $3 per share at the strike price of $47 you’d realize close to a $300 gain. But there is no guarantee it will go to $47 by the end of the contract; in which case you won’t reap this benefit; or worse, if it goes to $51, you’ll still only receive the contract price of $47.

In summary, my goal isn’t to explain Option trading in detail or encourage readers to spend their golden years analyzing Option chains. Rather, I want to share what I’ve learned over the years dealing with clients who want to try Options for extra income. The possibilities and logic are there but, for small, more conservative investors, don't feel like you're missing out on the next big thing or that covered calls are crucial to your financial success. Your time may be better utilized employing other strategies.

P.S. Let me know how you feel about Options for retirement income and what your experience has been? Share your thoughts and ideas in the comment section below ... and thanks for following me at Forbes.com and on @robertlaura